Great Debates: Actively Managed vs. Index Funds

On the face of it, this match up shouldn’t be a Great Debate; it shouldn’t even be a minor scuffle.  After all, everyone knows that Index Funds are the one and only type of mutual fund in which you should consider investing.  And every adviser from David Bach to Suze Orman (to say nothing of plenty of accountants, financial planners, and other money experts) says that if you’re going to invest in the stock market, you should do the smart thing and own the whole market. Hundreds of experts can’t be wrong, right?

Well, now, let’s just hold on a minute; there are some contrary voices out there, who raise some good arguments in favor of actively managed funds.  So, let’s take a deep breath, and look at index funds compared to actively managed funds for a minute.  To be sure, there are several advantages to index funds that appear readily under closer examination:

1) Lower expenses: One of the key selling points for index funds are their low, low, incredibly low expense rates.  A good S&P 500 Index fund can have expenses of only 0.10% (or less) annually, while an actively managed fund in the same sector will have an expense ratio of several times that amount (typically something like 1%).  Assuming the performance of the index fund is equal to that of the active fund before expenses, the index fund will have a higher return and final value for each dollar of your invested money.

2) Less Trading: In addition to expenses ratios, you also have to worry about taxes with your funds.  Index funds trade out their contents much less frequently than active funds, thus creating fewer short terms gains within the fund.  As a result, there are fewer taxable events within index funds, and fewer tax obligations to be passed onto you.

3) More Certainty: Because index funds hold everything (or at least, a large, representative sample) within a particular index, there should never be any doubt as to exactly what your fund will be holding.  There’s no worry about style drift, closet indexing or holding the wrong stocks with an index fund; you’ll be holding a major portion of the stocks (or bonds, REITs, or other investments) within the fund’s index, and only the investments within that index.

4) Generally beat actively managed funds: Not exactly something most mutual fund managers brag about (at least, those ones who are part of actively managed funds), but most mutual funds don’t beat the appropriate comparison indexes.  At least 70% of  actively managed mutual funds have under performed the S&P 500 index (and that’s one of the more generous values cited).  You can dodge this risk with an index fund.

Obviously, index funds have quite a advantages in their corner.  But actively managed mutual funds have at least one trick up their sleeve:

Index funds cannot beat the associated index.

If you invest in an index fund, by definition, you’re not going to be able to do better than the associated index; the holdings of the index fund are designed to replicate the index, keeping you from doing any better.  In fact, in the real world, index funds can’t even perform as well as the indexes they track, because the expense ratio will always be subtracted from the fund’s performance, decreasing the fund’s performance compared to the index.  In theory at least, an actively managed and controlled mutual fund can do better than the market.  However, as point four in favor of index funds notes, the percentage that actually do so is fairly rare.

What should you do then?  Well, when considering actively managed funds consider them as somewhere in between stocks and index funds in turns of risk, and treat them in your portfolio accordingly.  To help you do that, consider the following rules:

Limit the portion you put into actively managed funds – At least at first, until you have some experience researching and picking quality actively managed mutual funds, you should keep tight rein on the amount of your money you put into them.  Limit the actively managed mutual funds to a minimum in your account.  If you have 20% (or less) of your assets in actively managed fund(s) and the rest in a diverse group of index funds, you can essentially hedge your bet on the actively managed fund.  That way, if the actively managed fund(s) exceeds your expectations, you’ll still be a position to enjoy the profits; if it performs less well than you hope, you’ll be buoyed by the rest of your portfolio.

-Carefully watch your active funds – You have to treat active funds much more gingerly than index funds.  If you aren’t willing to closely monitor all you investments at least once a quarter (preferably, monthly or even weekly), you could find yourself losing a great deal of money there if your fund is unable to perform  Always be ready to close your account and move to another mutual fund, if the need arises; as with investing in individual stocks, you need to be alert.

-Lastly, make sure your active funds fit your portfolio – You can’t worry so much about chasing returns or hunting down a good active fund that you forget to ensure that your funds fit your your portfolio’s needs.  Instead, determine your ideal asset allocation, figure out your  contributions, and buy mutual funds (active or indexed) that fit your need.  (And if you do opt for active funds, be aware that the most successful ones tend to be in areas where there are exploitable market inefficiencies; small cap, international and emerging markets rather than large cap US funds are good places to consider.)

Keep this advice in mind, and you should be able to add active funds to your portfolio without sinking it.

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